- Productive efficiency is concerned with the optimal method of producing goods; producing goods at the lowest cost.
- Allocative efficiency is concerned with the optimal distribution of goods and services.
Example: An economy could be productively efficient in producing large numbers of boots – but if they were all for the left foot, it would be allocatively inefficient as no one would benefit from these low production costs.
Definition of productive efficiency
This is defined as producing goods and services for the lowest cost. Productive efficiency is said to occur on the production possibility frontier. On the PPF curve, it is impossible to produce more of one good without producing less of another.
In the diagram below, if you are at point A, you can’t produce more services without foregoing goods.
Point D in the graph is productively inefficient because you can produce more goods or services without an opportunity cost.
Lowest point on SRAC Curve
Productive efficiency also involves producing at the lowest point of the short run average cost curve (where MC cuts the bottom of the SRAC curve.)
Usually, productive efficiency refers to the short run (i.e. producing at the lowest point of SRAC curve) But if can also refer to producing at the lowest point on the Long Run Average Cost curve LRAC i.e. benefiting from economies of scale.
Related to productive efficiency is the concept of technical efficiency. Technical efficiency specifically refers to the optimal combination of inputs, i.e. using the minimum combination of labour and capital to produce a certain quantity of goods.
Allocative Efficiency definition
Allocative efficiency is quite different and is more concerned with the distribution and allocation of resources in society.
Allocative efficiency looks at the marginal benefit of consumption compared to the marginal cost. Allocative efficiency will occur at an output when marginal benefit (price) = marginal cost.
We can say:
- Allocative efficiency occurs where price = marginal cost (MC)
- Monopolies are often said to be allocatively inefficient because they are able to set the price higher than marginal cost. See: Monopoly
Related to allocative efficiency is the concept of social efficiency. Social efficiency makes a point of taking into account all externalities so we can try and equate social marginal benefit and social marginal cost.
Which is most important productive or allocative efficiency?
There would be no point in being productively efficient if all resources are diverted to making guns. We could be producing on a production possibility frontier but, if it is all guns, society would not have enough food or health care.
An anecdote from the Soviet Union under Communist days tells how factories were given targets to produce certain quantities of goods. They often did this with great vigour and were productively efficient, but, often they were producing goods which weren’t needed by society. There is a story that one factory made left-hand boots that nobody wanted, so at the end of the day they would efficiently burn them and the next day start again! They were productively efficient but not allocatively efficient.
However, productive efficiency is still important. If goods are produced at a lower cost it enables society to have a better trade-off and enable the scope for people to consume more goods and services.